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Diamond (1965).
57
58
3.1
Before going to the specics of Diamonds model, let us briey consider what
may motivate people to save:
(a) The life-cycle motive for saving. Typically, individual income has a
hump-shaped lifetime pattern; by saving and dissaving the individual
attempts to obtain the desired smoothing of consumption across lifetime. This is the essence of the life-cycle saving hypothesis put forward
by Nobel laureate Franco Modigliani (1918-2003) and associates in the
1950s.2 This hypothesis states that consumers plan their saving and
2
59
3.2
Horioka and Watanabe (1997) nd that empirically, the motives (a) and (b) are of
dominant importance (Japanese data).
C. Groth, Lecture notes in macroeconomics, (mimeo) 2011
60
61
Period
Generation
(time of birth)
-1
old
young
time
old
young
old
right to use one unit of someone elses physical capital through period . So
the owner of
units of physical capital receives a
(3.1)
(3.2)
This no-arbitrage condition indicates how, in equilibrium, the rental rate for
capital and the more everyday concept, the interest rate, are related. And
although no loan market is operative in the present model, we follow the
tradition and call the right-hand side of (3.1) the interest rate.
C. Groth, Lecture notes in macroeconomics, (mimeo) 2011
62
Meaning
1
2
=
+1
[0 1]
=
Table 3.1 provides an overview of the notation. As to our timing convention, notice that any stock variable dated indicates the amount held
at the beginning of period That is, the capital stock accumulated by the
end of period
1 and available for production in period is denoted
Thus we write
= (1
)
= (
) where () is an
1+
1 and
aggregate production function. In this context it is useful to think of period
as running from date to date + 1 i.e., the time interval [ + 1) on a
continuous time axis. Still, all decisions are taken at discrete points in time,
=0 1 2
(dates). We imagine that both receipts for work and lending
and payment for consumption in period occur at the end of the period.
These timing conventions are common in discrete-time growth and business
cycle theory.4 They are convenient because they make switching between
discrete and continuous time analysis fairly easy.
3.3
63
2 +1 )
=
= (1 + +1 )
0 2 +1 0
) + (1 + )
and
2 +1 )
+1
is:
s.t.
(3.3)
1)
(3.4)
(3.5)
(3.6)
2 +1
2 +1
1
0)
(
+1
The interpretation of the variables is given in Table 3.1 above. We may think
of the young as a household of one adult and 1 + children whose consumption is included in 1 Note that utility appears at two levels. There
is a lifetime utility function, ( 1 2 +1 ) and a period utility function, ( ) 5
The latter is assumed to be the same in both periods of life (this simplies
notation and has no e ects on the qualitative results). The period utility
function is assumed continuous and twice continuously di erentiable with
0
0 and 00
0 (positive, but diminishing marginal utility of consumption). Many popular specications of , e.g., ( ) = ln have the property
that lim 0 ( ) =
; then we dene (0) =
The parameter is called the rate of time preference. It acts as a utility
discount rate, whereas (1 + ) 1 is a utility discount factor. Thus indicates
the degree of impatience w.r.t. utility. By denition,
1 but we often
assume
0. When preferences can be represented in this additive way,
they are called time-separable. In principle, as seen from period the interest
rate appearing in (3.5) should be interpreted as an expected real interest rate.
But as long as we assume perfect foresight, there is no need to distinguish
between actual and expected magnitudes.
In (3.5) the interest rate acts as a rate of return on saving.6 We may
also interpret the interest rate as a discount rate relating to consumption
over time. For example, by isolating in (3.5) and substituting into (3.4)
we consolidate the two period budget constraints of the individual into one
intertemporal budget constraint,
1
1
1+
2 +1
(3.7)
+1
Other names for these two functions are the intertemporal utility function and the
subutility function, respectively.
6
While
in (3.4) appears as a ow (non-consumed income), in (3.5)
appears as a
stock (the accumulated nancial wealth at the begining of period + 1). This notation is
legitimate because the magnitude of the two is the same.
C. Groth, Lecture notes in macroeconomics, (mimeo) 2011
64
(No Fast).
(A1)
) + (1 + )
1 0
((1 +
+1 )
)(1 +
+1 )
((1 +
+1 )
)(1 +
2
+1 )
=0
(FOC)
(SOC)
00
) + (1 + )
1 00
Hence there can at most be one satisfying (FOC). Moreover, for a positive
wage income there always exists such an
Indeed:
7
The simple optimization method used here is called the substitution method : by substitution of the constraints into the objective function an unconstrained maximization
problem is obtained. Alternatively, one can use the Lagrange method.
C. Groth, Lecture notes in macroeconomics, (mimeo) 2011
65
LEMMA 1 Let
0 and suppose the No Fast assumption (A1) applies.
Then the saving problem of the young has a unique solution . The solution
is interior, i.e., 0
and satises (FOC).
(0 )
Proof. Assume (A1). For any
endpoints = 0 and =
By (FOC) and (A1),
lim
lim
( ) + (1 + ) 1 (1 +
lim
+1 )
lim
) + (1 + ) 1 (1 +
((1 +
+1 )
((1 +
+1 )
)=
+1 )
)=
(0 ) such that
is unique.
) = (1 + )
1 0
2 +1 )(1
+1 )
(3.8)
This is an example of what is called an Euler equation, after the Swiss mathematician L. Euler (1707-1783) who was the rst to study dynamic optimization problems. In the present context the condition is called a consumption
Euler equation.
The equation says that in an optimal plan the marginal utility cost of
saving equals the marginal utility benet obtained by doing that. More
specically: the opportunity cost (in terms of current utility) of saving one
more unit of account in the current period must be equal to the benet of
having 1 + +1 more units of account in the next period. This benet is
the discounted extra utility that can be obtained next period through the
increase in consumption by 1 + +1 units.
It may seem odd to express the intuitive interpretation of an optimality
condition the way we just did, that is, in terms of utility units. The utility concept is just a convenient mathematical device used to represent the
assumed preferences. Our interpretation is only meant as an as-if interpretation: as if utility were something concrete. A full interpretation in terms
of measurable quantities goes like this. We rewrite (3.8) as
0
(1 + )
1 )
1 0(
2 +1 )
=1+
+1
(3.9)
66
The left-hand side measures the marginal rate of substitution (MRS) of consumption as old for consumption as young, dened as the increase in period
+ 1 consumption needed to compensate for a one-unit marginal decrease in
period consumption. That is,
2 1
2 +1
(1 + )
1 )
1 0(
2 +1 )
(3.10)
And the right-hand side of (3.9) indicates the marginal rate of transformation,
MRT, which is the rate at which saving allows an agent to shift consumption
from period to period + 1 In an optimal plan MRS must equal MRT.
Note that when consumption is constant, (3.9) gives 1 + = 1 + +1 In this
(and only this) case will the utility discount rate coincide with the income
discount rate, the real interest rate.
Even though interpretations in terms of MRS equal to MRT are more
satisfactory, we will often use as if interpretations like the one before. They
are a convenient short-hand for the more elaborate interpretation.
The Euler equation (3.8) is a discrete time analogue to what is called the
Keynes-Ramsey rule in continuous time models (cf. Chapter 9). A simple
implication of the rule is that
Q
+1
causes
)R
2 +1 )
i.e.,
2 +1
0 That is, absent uncertainty the optimal plan entails eiin view of 00
ther increasing, constant or decreasing consumption over time according to
whether the rate of time preference is below, equal to, or above the market
interest rate, respectively. For example, when
+1 the plan is to start
with relatively low consumption in order to take advantage of the relatively
high rate of return on saving.
Properties of the saving function
There are innitely many pairs ( 1 2 +1 ) satisfying the Euler equation (3.8).
Only when requiring the two period budget constraints, (3.4) and (3.5), satised, do we get a unique solution for 1 and 2 +1 or, equivalently, for as
in Lemma 1. We now consider the properties of saving as a function of the
market prices faced by the decision maker.
With the budget constraints inserted as in (FOC), this equation determines the saving of the young as an implicit function of
and +1 i.e.,
= (
)
The
partial
derivatives
of
this
function
can
be
found by using
+1
the implicit function theorem on (FOC). A practical procedure is the following. We rst write
as a function of the variables involved,
and
C. Groth, Lecture notes in macroeconomics, (mimeo) 2011
+1
67
i.e.,
) + (1 + )
By (FOC), (
1 0
+1 )
)(1 +
+1 )
+1 )
+1 )
()
((1 +
and
()
+1
+1
where
0 by (SOC). We nd
()
()
()
00
= (1 + )
)
1
0
[ 0(
2 +1 )
00
2 +1 )
(1 +
+1 )]
+1
00
0 (but
(1 + ) 1 [ 0 (
2 +1 )
= (
(3.11)
1)
+
+1 )
00
2 +1 ) 2 +1 ]
(3.12)
+1
68
of a rise in the interest rate are of opposite signs. The substitution e ect
on 1 is negative because the higher interest rate makes future consumption
cheaper in terms of current consumption. And the income e ect on 1 is
positive because a given budget, cf. (3.7), can buy more consumption in both
periods. Generally there would be a third Slutsky e ect, a wealth e ect of a
rise in the interest rate, but such an e ect is ruled out in this model. This
is because there is no labor income in the second period of life. Indeed, as
indicated by (3.4), the human wealth of a member of generation is simply
, which is independent of +1
Rewriting (3.12) gives
=
(1 + )
1 0
2 +1 )[
2 +1 )
1]
T 0 for (
2 +1 )
S1
(3.13)
2 +1 )
2 +1
0(
2 +1 )
00
2 +1 )
2 +1 )
2 +1
2 +1 )
2 +1
69
the saving of the young. What is the intuition behind this? Neutrality visa-vis the saving of the young of a rise in the interest rate requires that 1
remains unchanged since 1 =
. In turn this requires that the marginal
0
utility, ( 2 +1 ) on the right-hand side of (3.8) falls by the same percentage
as 1+ +1 rises. The budget (3.5) as old, however, tells us that 2 +1 must rise
by the same percentage as 1+ +1 is should remain unchanged. Altogether
we thus need that 0 ( 2 +1 ) falls by the same percentage as 2 +1 rises. But
this requires that the absolute elasticity of 0 ( 2 +1 ) w.r.t. 2 +1 is exactly
one.
The elasticity of marginal utility, also called the marginal utility exibility, will generally depend on the level of consumption, as implicit in the
notation ( 2 +1 ) A popular special case is however the following.
EXAMPLE 1 The CRRA utility function. If we impose the requirement that
( ) should have an absolute elasticity of marginal utility of consumption
equal to a constant
0 then one can show (see Appendix A) that the
utility function must be of the so-called CRRA form
( )=
ln
when 6= 1
when = 1
(3.14)
70
u(c)
=0
= 0.5
=1
=2
=5
1
1
1 + (1 + ) (1 +
+1 )
(3.15)
and
We see that the signs of
+1 shown in (3.11) and (3.13),
respectively, are conrmed. Moreover, in this special case the saving of the
young is proportional to income with a factor of proportionality that depends
on the interest rate (as long as 6= 1). But in the general case the savingincome ratio depends also on the income level.
A major part of the attempts at empirically estimating suggests that
1 Based on U.S. data, Hall (1988) provides estimates above 5 while
Attanasio and Weber (1993) suggest 1 25
3 33 For Japanese data
Okubo (2011) suggests 2 5
5 0 According this evidence we should
expect the income e ect on current sonsumption of an increase in the interest
rate to dominate the substitution e ect, thus implying
0 as long as
there is no wealth e ect (On the other hand, it is not obvious that these
econometric estimates are applicable to a period length as long as that in the
Diamond model, about 30 years.)
When the elasticity of marginal utility of consumption is a constant, its
inverse, 1
equals the elasticity of intertemporal substitution in consump10
The name CRRA is a short form of Constant Relative Risk Aversion and comes from
the theory of behavior under uncertainty. Also in that theory does the CRRA function
constitute an important benchmark case; is called the degree of relative risk aversion.
C. Groth, Lecture notes in macroeconomics, (mimeo) 2011
71
that is,
at the point ( 1 2 ) is the absolute value of the slope of the
tangent to the indi erence curve at that point.11 Under the normal assumption of strictly convex preferences,
is rising along the curve when
decreases
(and
thereby
increases).
Conversely,
we can let
be the
1
2
independent variable and consider the corresponding point on the indi erence curve, and thereby the ratio 2 1 , as a function of
. If we raise
along the indi erence curve, the corresponding value of the ratio 2 1
will also rise.
The elasticity of intertemporal substitution in consumption at a given
point is dened as the elasticity of the ratio 2 1 w.r.t. the marginal rate of
substitution of 2 for 1 when we move along the indi erence curve through
the point ( 1 2 ). Let the elasticity of a di erentiable function ( ) w.r.t.
be denoted E ( ) Then the elasticity of intertemporal substitution in
consumption is
E
1)
=
2
1)
2
2
1)
1
2
1
( 1)
=1+
(1 + ) 1 0 ( 2 )
11
(3.16)
When the meaning is clear from the context, to save notation we just write
instead of the more precise
2 1
C. Groth, Lecture notes in macroeconomics, (mimeo) 2011
72
c2
new c2 / c1
c2 / c1
u(c1 ) (1
) 1u (c2 ) U
MRS
MRS '
c1
increases to
2)
=
2
1)
2
2
1)
1
(3.17)
2)
+
( 1) +
2
=
2
1
1
( 2)
(3.18)
3.4. Production
3.4
73
Production
)=
( 1)
( )
00
(3.19)
where
Second,
(
(
)=
( )]
( )=
(3.20)
(3.21)
= 0 that is,
)
)=
( )]
( )
( )=
The interpretation is that the rm will in every period use capital up to the
point where the marginal product of capital equals the rental rate given from
the market. Similarly, the rm will employ labor up to the point where the
marginal product of labor equals the wage rate given from the market.
In view of 00 0 a satisfying (3.20) is unique. We will call it the desired
capital intensity. Owing to CRS, however, at this stage the separate factor
inputs, and are indeterminate; only their ratio, is determinate.13 We
will now see how the equilibrium conditions for the factor markets select the
factor prices and the level of factor inputs consistent with equilibrium.
13
It might seem that is overdetermined because we have two equations, (3.20) and
(3.21), but only one unknown. This reminds us that for arbitrary factor prices, and
there will not exist a satisfying both (3.20) and (3.21). But in equilibrium the factor
prices faced by the rm are not arbitrary. They are equilibrium prices, i.e., they are
adjusted so that (3.20) and (3.21) become consistent.
C. Groth, Lecture notes in macroeconomics, (mimeo) 2011
74
=
=
0 (1
(3.23)
+ )
( )
0
( )
0
where
= 00 ( )
0
( ) where
=
0
( )
00
(3.24)
(3.25)
75
To x ideas we have assumed that the households own the physical capital and rent it out to the rms. But as long as the model ignores uncertainty
and capital installation costs, the results will be una ected if instead we let
the rms themselves own the physical capital and nance capital investment
by issuing bonds and shares. These bonds and shares would then be accumulated by the households and constitute their nancial wealth instead of
the capital goods. The equilibrium rate of return, , would be the same.
3.5
3.5.1
+1
(3.26)
76
Let
1+
1+
= ( ) + (1
i.e.,
and ( ) we obtain
(1 + )
+1
(3.27)
The path {(
1
2 )} =0 is called technically feasible if 0 = 0 and for
= 0 1 2 . . . , (3.27) holds with
0 1
0 and 2
0.
Next we consider how, for given household preferences, the private-ownership
market institution with prot-maximizing rms under perfect competition
generates a selection within the class of technically feasible paths. A member (sometimes the unique member) of this selection is called an equilibrium
path and constitutes a sequence of states, temporary equilibria, with a certain
property.
3.5.2
A temporary equilibrium
(3.28)
77
Indeed, there is no bequest motive and so the old in any period consume all
they have and leave nothing as bequests. It follows that the young in any
period enter the period with no nancial wealth. So any nancial wealth
existing at the beginning of a period must belong to the old in that period
and be the result of their saving as young in the previous period. As
equals the aggregate nancial wealth in our closed economy at the beginning
of period (3.28) follows.
Recalling that net saving is by denition the same as the increase in
nancial wealth, the net saving of the old in period is thus
At the
same time this is the (negative) net investment of the old. Aggregate net
investment is thus
+(
) By denition, aggregate gross investment
equals aggregate net investment plus capital depreciation, i.e.,
=
Equilibrium in the goods market,
when
+ 2
1
1+
DEFINITION 2 For
be given as +1
a state (
1
2
markets clear) for 1
= ( ) 0 and
(3.29)
+
+
=
+
) therefore obtains
(
=
(3.30)
78
3.5.3
An equilibrium path
79
0 1 2 . . . , the state (
= ( +1 ).
+1
+1
+1
+1
+1
+1
( ( ) (
1+
+1 ))
(3.32)
using that = (
= ( ) and +1 = +1 = ( +1 ) in a se+1 )
quence of temporary equilibria with fullled expectations. Equation (3.32) is
a rst-order di erence equation, known as the fundamental di erence equation or the law of motion of the Diamond model.
PROPOSITION 2 Suppose the No Fast assumption (A1) applies. Then,
(i) for any 0 0 there exists at least one equilibrium path;
(ii) if and only if (0) 0 (i.e., capital not essential), does an equilibrium
path exist even for 0 = 0;
(iii) in any case, an equilibrium path has positive real wage in all periods and
positive capital in all periods except possibly the rst;
(iv) an equilibrium path satises the rst-order di erence equation (3.32).
Proof. As to (i) and (ii), see Appendix D. (iii) For a given let
0
Then, since an equilibrium path is a sequence of temporary equilibria, we
have
= ( ) 0 and = ( ( ) +1 ), where +1 = ( +1 ) Hence,
by Lemma 1, ( ( ) +1 ) 0 which implies +1 0 in view of (3.32).
This shows that only for = 0 is = 0 possible along an equilibrium path.
Finally, (iv) was shown in the text above (3.32).
The formal proofs of point (i) and (ii) of the proposition are placed in
appendix because they are rather technical. But the graphs in the ensuing
gures 3.4-3.7 provide an intuitive verication. The only if part of point
(ii) reects the not very surprising fact that if capital were an essential
production factor, no capital now would imply no income now, hence
no investment and thus no capital in the next period and so on. On the
other hand, the if part of point (ii) says that when capital is not essential,
an equilibrium path can set o even from an initial period with no capital.
Then point (iii) adds that an equilibrium path will have positive capital in
all subsequent periods. Finally, as to point (iv), note that the fundamental
di erence equation, (3.32), rests on equation (3.31). The economic logic
behind this key equation is as follows: Since capital is the only nancial
C. Groth, Lecture notes in macroeconomics, (mimeo) 2011
80
asset in the economy and the young are born without any inheritance, the
aggregate capital stock at the beginning of period + 1 must be owned by
the old generation in that period and thus be equal to the aggregate saving
these people had in the previous period when they were young.
Transition diagrams
To be able to further characterize equilibrium paths we construct a transition diagram in the (
+1 ) plane. The transition curve is dened as the
set of points, (
+1 ) satisfying (3.32). Fig. 3.4 shows a possible, but not
necessary conguration of this curve. A complicating circumstance is that
the equation (3.32) has +1 on both sides. Sometimes we are able to solve
the equation explicitly for +1 as a function of
but sometimes we can do
so only implicitly. What is even worse is that there are cases where +1 is
not unique for given
We will proceed step by step.
First, what can we say about the slope of the transition curve? In general
a point on the transition curve has the property that at least in a neighborhood of this point the equation (3.32) will dene +1 as an implicit function
of .14 Taking the total derivative w.r.t.
on both sides of (3.32), we get
1
+1
+1
0
0
(3.33)
=
() ( ) + () ( +1 )
1+
By ordering and using (3.24) and (3.25), the slope of the transition curve can
be written
00
( ( ) ( +1 ))
( )
+1
(3.34)
=
00
1+
( ( ) ( +1 )) ( +1 )
when [ ( ) ( +1 )] 00 ( +1 ) 6= 1+
is always positive and we have
+1
0 for
Since
[ ( ) (
+1 )]
respectively, where (1 + ) 0 ( +1 ) = (1 + ) 00 ( +1 ) 0
It follows that the transition curve is universally upward-sloping if and
only if [ ( ) ( +1 )] (1 + ) 0 ( +1 ) everywhere along the transition
curve. The intuition behind this becomes visible by rewriting (3.33) in terms
of di erentials w.r.t. +1 and :
(1 +
14
()
+1 ))
+1
()
( )
kt
81
k*
45
k0
k*
kt
Figure 3.4: Transition curve and the resulting dynamics in the log utility CobbDouglas case.
00
where () 0 0 ( ) =
( ) 0, and 0 ( +1 ) = 00 ( +1 ) 0 Now,
a rise in
will always raise wage income and, via the resulting rise in
raise +1 everything else equal. Everything else is not equal, however, since
a rise in +1 implies a fall in the rate of interest. Yet, if () = 0 there is
no feedback e ect from this and so the tendency to a rise in +1 is neither
o set nor fortied. If () 0 the tendency to a rise in +1 will be partly
o set through the dampening e ect on saving resulting in this case from the
fall in the interest rate. This negative feedback e ect can not fully or more
than fully o set the tendency to a rise in +1 . This is because the negative
feedback on the saving of the young will only be there if the interest falls
in the rst place. We cannot have both a fall in the interest rate triggering
lower saving and a rise in the interest rate (via a lower +1 ) because of the
lower saving.
On the other hand, if () is su ciently negative, then the initial tendency to a rise in +1 via the higher wage income in response to a rise can
be more than fully o set by a rise in the interest rate leading in this case to
lower saving by the young, hence lower +1 .
So a su cient condition for a universally upward-sloping transition curve
is that the saving of the young is a non-decreasing function of the interest
rate.
82
+1
6= 0
Proof. Since
(1
)
(1 + )(2 + )
(3.35)
This would not necessarily hold if the utility function were not separable in time.
kt
83
k'
k ''
k '''
45
k
kt k1* k
kt
k 2*
+1
which is then
84
the slope of the transition curve is negative. As we saw above, this requires
not only that in this neighborhood (
( +1 )) 0, but that the stricter
condition (
( +1 )) (1 + ) 00 ( 00 ) holds (we take
as given since
00
is given and
= ( )). That the point P with coordinates (
) is on
the transition curve indicates that given
= ( ) and an expected interest
rate +1 = ( 00 ) the induced saving by the young, (
( 00 ) will be such
that +1 = 00 that is, the expectation is fullled. The fact that also the
0
00
point (
) where 0
, is on transition curve indicates that also a lower
0
interest rate, ( ) can be self-fullling. By this is meant that if an interest
rate at the level ( 0 ) is expected, then this expection induces more saving by
00
the young just enough more to make +1 = 0
, thus conrming the
0
expectation of the lower interest rate level ( ) What makes this possible
is exactly the negative dependency of on +1 The fact that also the point
000
00
(
) where 000
, is on transition curve can be similarly interpreted.
It is again
0 that makes it possible that a lower saving than at P can
be induced by an expected higher interest rate, ( 000 ) than at P.
These ambiguities point to a serious problem with the assumption of
perfect foresight. The model presupposes that all the young agree in their
expectations. Only then will one of the three mentioned temporary equilibria appear. But the model is silent about how the needed coordination of
expectations is brought about, and if it is, why this coordination ends up
in one rather than another of the three possible equilibria with self-fullling
expectations. Each single young is isolated in the market and will not know
what the others will expect. The market mechanism as such provides no
coordination of expectations. As it stands, the model cannot determine how
the economy will evolve in this situation.
There are di erent ways to deal with (or circumvent) the di culty. We
will consider two of them. One simple approach is to discard the assumption
of perfect foresight. Instead, some kind of adaptive expectations may be
assumed, for example in the form of myopic foresight (sometimes called static
expectations). This means that the expectation formed by the agents this
period about the value of a variable next period is that it will stay the same
as in this period.16 So here the assumption would be that the young have the
expectation +1 = . Then, given 0 0 a unique sequence of temporary
equilibria {(
)} =0 is generated by the model. Oscillations in
1
2
the sense of repetitive movements up and down of
are possible. Even
chaotic trajectories are possible (see Exercise 3.6).
16
This expectation will in certain contexts be rational (model consistent). This will for
instance be the case if the variable about which the expectation is held follows a random
walk. In the present context the myopic expectation is not rational, however, unless the
economy is already from the beginning in steady state.
C. Groth, Lecture notes in macroeconomics, (mimeo) 2011
85
Outside steady state the agents will experience that their expectations
are systematically wrong. And the assumption of myopic foresight rules out
that learning occurs. Whether this is an acceptable approximation depends
on the circumstances. In the context of the Diamond model we might say
that although the old may be disappointed when they realize that their expectations turned out wrong, it is too late to learn because next period they
will be dead. On the other hand, it is natural to imagine that social interaction occurs in a society and so the young might learn from the mistakes by
the old. But such aspects are not part of the model as it stands.
Another approach to the indeterminacy problem is motivated by the presumption that the possibility of multiple equilibria in the Diamond model
is basically due to the rough time structure of the model. Each period in
the model corresponds to half of an adult persons lifetime. Moreover, in the
rst period of life there is no capital income, in the second there is no labor
income. This coarse notion of time may articially generate multiplicity of
equilibria or, with myopic foresight, oscillations. An expanded model where
people live many periods might smooth the responses of the system to the
di erent events impinging on it. The analyst may nevertheless in a rst approach want to stay with the rough time structure of the model because of its
analytical convenience and then make the most of it by imposing conditions
that rule out multiple equilibria.
Following this approach we stay with the assumption of perfect foresight,
but assume that circumstances are such that multiple temporary equilibria
with self-fullling expectations do not arise.
Conditions for uniqueness of the equilibrium path
Su cient for the equilibrium path to be unique is that preferences and technology in combination are such that the slope of the transition curve is everywhere positive. As we saw in connection with (3.34), this requires that the
dependency of the saving of the young on is not too negative, that is,
[ ( ) (
+1 )]
1+
00 (
+1 )
(A2)
86
+1 )1
(b) If the production function is of CES-type,17 i.e., ( ) = (
0 0
1
1 then (A2) holds along an equilibrium
path even for
1 if the elasticity substitution between capital and
labor, 1 (1
) is not too small, i.e., if
1
1
for all
1 + (1 + )
1 1
(1 +
0(
)(1
(3.36)
= ( )
17
CES stands for Constant Elasticity of Substitution. CES production functions are
considered in detail in Chapter 4.
C. Groth, Lecture notes in macroeconomics, (mimeo) 2011
87
for all
0 where ( ) is called a transition function. The derivative
of this implicit function is given by (3.34) with +1 on the right-hand side
replaced by ( ) i.e.,
0
( )=
( ( ) ( ( )))
( ( ) ( ( )))
1+
00
( )
00 ( ( ))
(3.37)
From now, our transition curve will represent this transition function and
thus have positive slope everywhere.
Existence and stability of a steady state?
To address the question of existence of steady states, we examine the possible
congurations of the transition curve in more detail. A useful observation is
that the transition curve will always, for
0 be situated strictly below
the solid curve, +1 = ( ) (1 + ), in Fig. 3.6. In turn, the latter curve is
always, for
0 strictly below the stippled curve, +1 = ( ) (1 + ), in
the gure. To be precise:
PROPOSITION 5 (ceiling and roof) Suppose the No Fast assumption (A1)
applies. Along an equilibrium path, whenever
0
0
+1
( )
1+
( )
1+
= 0 1 ....
+1
1+
1+
0
( )
( )
( )
=
1+
1+
( )
( )
1+
where the rst equality comes from (3.32), the second inequality from Lemma
1 in Section 3.3, and the last inequality from the fact that 0 ( )
0 when
0.
We will call the graph (
( ) (1 + )) in Fig. 3.6 a ceiling. It acts as
a ceiling on +1 simply because the saving of the young cannot exceed the
income of the young, ( ) And we will call the graph (
( ) (1 + )) a
roof, because everything of interest occurs below it.
To characterize the position of the roof relative to the 45 line, we consider
the lower Inada condition, lim 0 0 ( ) = .
LEMMA 2 The roof, +1 = ( ) (1 + ) has positive slope everywhere,
crosses the 45 line for at most one
0 and can only do that from above.
A necessary and su cient condition for the roof to be above the 45 line for
C. Groth, Lecture notes in macroeconomics, (mimeo) 2011
88
kt
f (kt )
1 n
w(kt )
1 n
45
kt
k0
Figure 3.6: The roof crosses the 45 line, but the transition curve does not (no
steady state exists).
( )=
holds or
Proof. Since 0
0 the roof has positive slope. Since 00
0 it can only
0
cross the 45 line once and only from above. If lim 0 ( ) =
holds, then
for small the roof is steeper than the 45 line. Therefore, close to the origin
the roof will be above the 45 line. Obviously, (0) 0 is also su cient for
this.
But the roof being above the 450 line for small
is not su cient for
the transition curve to be so. Fig. 3.6 illustrates this. Here the transition
curve is in fact everywhere below the 450 line In this case no steady state
exists and the dynamics imply convergence towards the catastrophic point
(0 0) Given the rate of population growth, the saving of the young is not
su cient to avoid famine in the long run. This will for example happen
if the technology implies so low productivity that even if all income of the
young were saved, we would have +1
for all
0 cf. Exercise 3.2.
The Malthusian mechanism will be at work and bring down (outside the
model). This exemplies that even a trivial steady state (the point (0,0))
may be of interest in so far as it may be the point the economy is heading to
without ever reaching it.
To help existence of a steady state we will impose the condition that
either capital is not essential or preferences and technology t together in
C. Groth, Lecture notes in macroeconomics, (mimeo) 2011
89
such a way that the slope of the transition curve is larger than one for small
. That is, we assume that either
(i)
(ii)
lim
(0)
( )
or
0
1
(A3)
( )
(A4)
1+
( )
( )
( )
( )
( )
and
( )
90
kt
f (kt )
1 n
w(kt )
1 n
f (0)
1 n
45
k1*
k2*
k3*
kt
3.6
91
An economy described by the Diamond model has the property that even
though there is perfect competition and no externalities, the outcome brought
about by the market mechanism may not be Pareto optimal.19 Indeed, the
economy may overaccumulate forever and thus su er from a distinctive form
of production ine ciency.
The key element in understanding the concept of overaccumulation is the
concept of a golden rule capital intensity. Overaccumulation occurs when
aggregate saving maintains a capital intensity above the golden rule value
forever. Let us consider these concepts in detail.
The golden rule
Consider the economy-wide resource constraint
=
= (
)
( +1
+
) From this follows that consumption per unit of labor is
= ( ) + (1
(1 + )
+1
(3.38)
( )
(3.39)
( + )=0
(3.40)
( + )
( )=
( )
19
Recall that a Pareto optimal state or path is a technically feasible path with the
property that no other technically feasible path will make at least one individual better
o without making someone else worse o . A technically feasible path which is not Pareto
optimal is called Pareto inferior.
C. Groth, Lecture notes in macroeconomics, (mimeo) 2011
92
n
y
c(k * )
f (k )
n)k
c(kGR )
kGR
k*
That is:
PROPOSITION 7 (the golden rule) The highest sustainable consumption
level per unit of labor in society is obtained when in steady state the net
marginal productivity of capital equals the growth rate of the economy.
In words: If a society aims at the highest sustainable level of consumption, it should increase its capital intensity up to the point where the extra
output obtainable by a further small increase is exactly o set by the extra
gross investment needed to maintain the capital intensity at that level. The
intuition is visible from (3.39). The golden rule capital intensity,
strikes
the right balance in the trade-o between high output per unit of labor and a
not too high investment requirement. Although a steady state with
would imply higher output per unit of labor, it would also imply that a large
part (here ( + ) ) of that output is set aside for investment to counterweigh
capital depreciation and growth in the labor force. Without this investment
the high capital intensity
would not be maintained. With
this
feature would dominate the rst e ect so that consumption per unit of labor
ends up low. Fig. 3.8 illustrates.
C. Groth, Lecture notes in macroeconomics, (mimeo) 2011
93
The name golden rule hints at the golden rule from the Bible: Do unto
others as you would have them to do unto you. Let God ask the newly
born generation: What capital intensity would you prefer to be presented
with, given that you must hand over the same capital intensity to the next
generation? The appropriate answer is: the golden rule capital intensity!
The possibility of overaccumulation
The Diamond model implies an interest rate
As an implication,
T
( )
( )
in a steady state
= (1
) ; this leads to high saving by the young, since
0 The result
is a high +1 which generates a high real wage also next period and may in
this manner be sustained forever.
20
In this model with no utility of leisure, a tax on wage income, or a mandatory payas-you-go pension contribution (see Chapter 5) would act like a lump-sum tax on the
young.
C. Groth, Lecture notes in macroeconomics, (mimeo) 2011
94
An intuitive understanding of the fact that the perfectly competitive market mechanism can thus lead to overaccumulation, can also be based on the
following argument. Assume, rst, that
0. In this case, if the young
in period expects the rate of return on their saving to end up small (less
than ), the decided saving will be large in order to provide for consumption
after retirement. But the aggregate result of this behavior is a high +1 and
therefore a low 0 ( +1 ) In this way the expectation of a low +1 is conrmed
by the actual events. The young persons each do the best they can as atomistic individuals, taking the market conditions as given. Yet the aggregate
outcome is an equilibrium with overaccumulation, hence a Pareto-inferior
outcome.
Looking at the issue more closely, we see that
0 is not crucial for this
outcome. Suppose = 0 (the log utility case) and that in the current period,
is, for some historical reason, considerably above
. Thus, current wages
are high, hence, is relatively high (there is in this case no o setting e ect
on from the relatively low expected +1 ) Again, the aggregate result is a
high +1 and thus the expectation is conrmed. Consequently, the situation
in the next period is the same and so on. By continuity, even if
0 the
argument goes through as long as is not too large.
Dynamic ine ciency and the double innity
Another name for the overaccumulation phenomenon is dynamic ine ciency.
)} =0 such that there
DEFINITION 6 Any technically feasible path {(
does not exist another technically feasible path with higher in some periods
without smaller in other periods is called dynamically e cient. A technically feasible path {(
)} =0 which is not dynamically e cient is called
dynamically ine cient.
PROPOSITION 8 Any technically feasible path {(
is dynamically ine cient.
Proof. Let
2 ) implies
( )
+
(3.41)
)} =0 with
for
(the
Consider a technically feasible path {(
reference path) Then there exists a 0 such that for
(
+
)
0
0
0
and (
)
Consider an alternative feasible path
n( ) o
( )
where (a) for = 0 consumption is increased relative to the
=0
; and (b) for all
reference path such that +1 =
0 consumption
0
is such that +1 =
for all
0 , by (3.38),
=
=
95
( ) + (1
) (1 +
(
) + (1
)(
0
(
) + (1
( )
( ) ( + ) + (1
)
(1 +
( ) + (1
) +1
) (1 + )( +1
)
)(
) (1 + )( +1
)
(1 + ) +1 + ( + )
) +1 =
Indeed,
(by (3.41))
by (3.38)).
Moreover, it can be shown that:
PROPOSITION 9 Any technically feasible path {(
is dynamically e cient.21
Both this proposition and Proposition 8 were shown in a stronger form by the American economist David Cass (1937-2008). Cass established the general necessary and sufcient condition for a feasible path {(
)} =0 to be dynamically e cient (Cass 1972).
Our two propositions are more restrictive in that they are limited to paths that converge.
22
As we shall see later in this book, in the Ramsey model (which has a nite number of
innitely lived households or dynasties) a situation with
(dynamic ine ciency)
cannot be a market equilibrium.
C. Groth, Lecture notes in macroeconomics, (mimeo) 2011
96
authority can accomplish but the market can not. In a situation with
let the government decide to transfer one good from each young to the old.
Since there are (on average) 1 + young people for each old person, every
old receives in this way 1 + goods in the same period. Let this transfer
be repeated every future period. By decreasing their saving by one unit,
the young can maintain unchanged consumption in their youth, and when
becoming old, they receive 1+ goods from the next periods young and so on.
In e ect, the return on the initial payment by the young is 1 + which is
more than the 1 + that could be obtained through own saving. The reason
that nobody need loose by this kind of redistribution is the double innity:
the economy goes on forever and there is no last generation. Nonetheless,
some kind of centralized coordination is required to accomplish a solution.
As noted by Shell (1971) there is an analogy in Gamows bed problem:
There are an innite number of inns along the road, each with one bed. On
a certain rainy night all innkeepers have committed their beds. A late guest
comes to the rst inn and asks for a bed. Sorry, full up! But the minister
of welfare hears about it and suggests that each guest move down the road
one inn.23
Whether the theoretical possibility of overaccumulation should be a matter of practical concern is an empirical question about the relative size of rates
of return and economic growth. To answer the question meaningfully we need
an extension of the criterion for overaccumulation such that the presence of
technical progress and rising per capita consumption in the long run is taken
into account. This is one of the topics of the next chapter. We can already
here, however, reveal that there is no indication that overaccumulation has
ever been an actual problem in industrialized market economies.
A nal remark before concluding seems in place. It can be shown that
Proposition 7 about the golden rule can be generalized to the case where
instead of one there are di erent capital goods in the economy. Essentially
the generalization says that assuming concave neoclassical production functions with di erent capital goods as inputs, one consumption good, and
perfectly competitive markets, a steady state in which per capita consumption is maximized has interest rate equal to the growth of the labor force
(Mas-Colell, 1989).
3.7
Concluding remarks
Unnished.
23
George Gamow (1904-1968) was a Russian physicist. The problem is also known as
Hilberts hotel problem, after the German mathematician David Hilbert (1862-1943).
C. Groth, Lecture notes in macroeconomics, (mimeo) 2011
3.8
97
Bibliographic notes
98
3.9
Appendix
ln
when 6= 1
when = 1
(*)
1
+
when 6= 1
1
( )=
ln +
when = 1
where is an arbitrary constant. This proves the claim. Letting
we get (*).
=0
When we want to make the kinship between the members of the CRRA
family transparent, we maintain = 0 and for = 1 also = 0 whereas for
6= 1 we set = 1 (1
). In this way we achieve that all members of the
CRRA family will be represented by curves going through the same point as
the log function, namely (1 0), cf. Fig. 3.2. And adding or subtracting a
constant does not a ect marginal rates of substitution and consequently not
behavior.
The domain of the CRRA function We want to extend the domain to
include = 0 If
1 the CRRA function, whether in the form ( ) =
( 1
1) (1
) or in the form (*), is dened only for
0 not for = 0
This is because for
0 we get ( )
In this case we simply dene
(0) =
This will create no problems since the CRRA function anyway
has the property that 0 ( )
when
0 (whether is larger or smaller
than one). The marginal utility thus becomes very large as becomes very
small, that is, the No Fast assumption is satised. This will ensure that the
chosen is strictly positive whenever there is a positive budget. So we dene
the domain of the CRRA function to be [0 )
C. Groth, Lecture notes in macroeconomics, (mimeo) 2011
3.9. Appendix
99
The range
function Considering the CRRA function
1 of the CRRA
1
( )
1 (1
) for
[0 ) we have:
for 0
1 the range of ( ) is
for
= 1 the range of ( ) is [
for
1 the range of ( ) is [
(1
)
(1
) 1)
Thus, in the latter case ( ) is bounded above and so allows a kind of saturation to occur.
B. Deriving the elasticity of intertemporal substitution in consumption
Referring to Section 3.3, we here show that the denition of ( 1 2 ) in (3.17)
gives the result (3.18). Let
(1 + ) 1 Then the rst-order
2 1 and
condition (3.16) and the equation describing the considered indi erence curve
constitute a system of two equations
0
( 1) +
0
( 1) =
(
( 1) =
1)
[ 0( 1) +
00
1)
] 0( )
00
( )
1) 1
( )
(3.42)
(3.43)
Since
00
( )
00
( 1)
+
0( )
1
00
0(
1)
1)
( )=
( )
Finally, in view of
( )=
+
( 1) +
1)
2 ),
100
C. Walras law
In the proof of Proposition 1 we referred to Walras law. Here is how Walras
law works in a model like this. We consider period but for simplicity we
skip the time index on the variables. Suppose a Walrasian auctioneer
calls out the price vector (
1) where
0 and
0 and asks all
agents, i.e., the young, the old, and the representative rm, to declare their
supplies and demands.
The supplies of capital and labor are by assumption inelastic and equal
to units of capital services and units of labor services. But the demand
for capital and labor depends on the announced and
Let the potential
pure prot of the representative rm be denoted
If and are so that
0 the rm declares
= 0 and
= 0 If on the other hand at the
announced and
= 0 (as when = ( ) + and
= ( )) the
0 1
desired capital intensity is given as
=
() from (3.20), but the rm
is indi erent w.r.t. the absolute level of the factor inputs. In this situation
the auctioneer tells the rm to declare
= (recall is the given labor
supply) and
=
which is certainly acceptable for the rm. Finally, if
0 the rm is tempted to declare innite factor demands, but to avoid
that, the auctioneer imposes the rule that the maximum allowed demands
for capital and labor are 2 and 2 respectively Within these constraints
the factor demands will be uniquely determined by and and we have
=
1) =
(3.44)
The owners of both the capital stock and the representative rm must
be those who saved in the previous period, namely the currently old. These
elderly will together declare the consumption 2 1 = (1 +
) + and
the net investment
(which amounts to disinvestment). The young will
declare the consumption 1 =
(
+1 ) and the net investment
= (
)
So
aggregate
declared
consumption
will be = (1 + ) +
+1
+
(
= (
+1 ) and aggregate net investment
+1 )
It follows that + =
+ + The aggregate declared supply of output
is
= (
) The values of excess demands in the three markets now
add to
(
1)
(
=
=
) + (
+
+
)+
+
)+
+
+
=0
by (3.44).
This is a manifestation of Walras law: whatever the announced price
vector, the aggregate value of excess demands is zero. The reason is the
C. Groth, Lecture notes in macroeconomics, (mimeo) 2011
3.9. Appendix
101
following. When each household satises its budget constraint and each rm
pays out its pure prot, then the economy as a whole has to satisfy an
aggregate budget constraint.
To be precise the demands and budget constraints considered in the
thought experiment (and in Walras law in general) are the Walrasian demands and budget constraints. Outside equilibrium these are somewhat
articial constructs. A Walrasian budget constraint, for instance, is based
on the assumption that the desired actions can be realized. This assumption
will be wrong unless and are already at their equilibrium levels. But the
assumption is never falsied because the thought experiment does not allow
trades to take place outside equilibrium. Similarly, the Walrasian consumption demand by the worker is rather hypothetical outside equilibrium. This
demand is based on the income the worker would get if fully employed at the
announced real wage, not on the actual employment (or unemployment) at
that real wage.
These ambiguities notwithstanding, the important implication of Walras
law goes through, namely that when two of the three markets clear, so does
the third.
D. Proof of (i) and (ii) of Proposition 2
For convenience we repeat the fundamental di erence equation characterizing
an equilibrium path:
+1
( ( ) (
1+
+1 ))
0
0
( )
0 for all
0 and ( )
( )
1
where ( )
( )
for all
0 The key to the proof of Proposition 2 about existence of an
equilibrium path is the following lemma.
( ))
=1+
(3.45)
( ))
102
s
k
s
k
s (w, r (k ))
k
s(w, r (k ))
k
1 n
1 n
is
lim ( ) =
0
( ))
(
)
[1 + ( )]
( (
)) = (1 + )
(
1+ ( )
( ))
(1 + )
24
( )
1+ ( )
If the limit does not exist, the proof applies to the limit inferior of (
( )) for
0 The limit inferior for
of a sequence { } =0 is dened as lim
inf { | =
+ 1 . . . } where inf of a set
={ | =
+ 1 . . . } is dened as the greatest lower
bound for .
25
If the limit does not exist, the proof applies to the limit inferior of (
( )) for
0
C. Groth, Lecture notes in macroeconomics, (mimeo) 2011
3.9. Appendix
103
)) = (1 + ) lim
(
1+ ( )
( )))
( )
=0
01+ ( )
= (1 + ) lim
where the second equality comes from the fact that we are in case 2 and the
0 and 00 ( )
0 for all
0
third comes from (3.46). But since 0 ( )
0
lim 0 ( (
)) = 0 requires lim 0 (
) = , as was to be shown
In both Case 1 and Case 2 we thus have that
0 implies (
( ))
. Since (
( ))
is a continuous function of there must be at least
one
0 such that (3.45) holds (as illustrated by the two graphs in Fig.
3.14).
Now, to prove (i) of Proposition 2, consider an arbitrary
0 We have
( )
0 In (3.45), let = ( ). By Lemma C1, (3.45) has a solution
0. Set +1 = Starting with = 0 from a given 0 0 we thus nd
a 1
0 and letting = 1 from the now given 1 we nd a 2 and so on.
The resulting innite sequence { } =0 is an equilibrium path. In this way
we have proved existence of an equilibrium path if 0
0 Thereby (i) of
Proposition 2 is proved
But what if 0 = 0? Then, if (0) = 0 no temporary equilibrium is
possible in period 0, in view of (ii) of Proposition 1; hence there can be no
equilibrium path. Suppose (0)
0 Then ( 0 ) = (0) = (0)
0 as
explained in Technical Remark in Section 3.4. Let in equation (3.45) be
equal to (0) By Lemma C1 this equation has a solution
0. Set 1 =
Letting period 1 be the new initial period, we are back in the case with initial
capital positive. This proves (ii) of Proposition 2.
E. Su cient conditions for the transition curve to obtain certain
properties
Positive slope everywhere For convenience we repeat here the condition
(3.36):
1
1
(*)
1
1 + (1 + ) (1 + 0 ( )
) 1
where we have substituted
1
In Section 3.5.3 we claimed that in the
CRRA-CES case this condition is su cient for the transition curve to be
positively sloped everywhere. We here prove the claim.
Consider an arbitrary
0 and let
( )
0 Knowing that
0
( ) 0 for all
0 we can regard +1 as directly linked to
With
representing +1 , must satisfy the equation = (
( )) (1 + ) A
su cient condition for this equation to implicitly dene as an increasing
C. Groth, Lecture notes in macroeconomics, (mimeo) 2011
104
function of
is also a su cient condition for the transition curve to be
positively sloped for all
0
When ( ) belongs to the CRRA class, by (3.15) with
1
we have
1
1
(
( )) = [1 + (1 + ) (1 + ( )) ]
The equation = (
( )) (1+
) therefore implies
1+
1 + (1 + )
where ( ) 1 + ( ) 1 + 0 ( )
a su cient condition for obtaining
0
( ) = 1 + (1 + )
( )1
(3.47)
( )
0 for all
0 It remains to provide
( ) 0 for all
0 We have
( )1
[1
(1
) ( )]
(3.48)
0
since ( )
( ) ( ) 0 the sign being due to 0 ( ) = 00 ( ) 0
So 0 ( ) 0 if and only if 1 (1
) ( )
(1 + )
( ) 1 a condition
equivalent with
1
1
(3.49)
( )
1 + (1 + )
( ) 1
To make this condition more concrete, consider the CES production function
( )= (
+1
)
0 0
1
1
(3.50)
Then
( )=
( ) = (1
( ( )
)
(1
1
)1
and dening ( )
( )) 0 ( )
+ 0( )
(1
)(1
( ) we nd
( )
( ))
(3.51)
3.9. Appendix
105
If
( )=
+1 )
( )
(1 + ) 0 (
0 is a steady-state value of
(3.52) implies
( )1
1 + (1 + )
+1 )
( )
(1 + )
(3.53)
and the slope of the transition curve at the steady state will be
0
( )=
( )
(1 + ) 0 ( )
(3.54)
If we can show
is unique and that 0 ( ) 1 then the transition curve
crosses the 45 line from above, and we are done.
1
2
where 0 ( ) = (
1)
0
Dening ( )
( )
=
and using that ( ) =
we have ( ) = 1 + ( )
and ( ) =
(1
) ( ) Hence, (3.53) can be written
)1
1 + (1 + ) (1 +
1
1+
(3.55)
where
= ( ) It is easy to show graphically that this equation has
a unique solution
0 whether
1
= 1 or
1 Then
=
1 ( 1)
(
)
0 is also unique.
By (3.48) and (3.55),
0
1
1+
1
1+(
1+
( ) = 1+(
1) [1
(1
) ( )]
1+(
1
1+
1)
1)(1
( ))
106
( )
1+
(3.56)
as was to be shown.
The CRRA-Cobb-Douglas case is well-behaved For the case of CRRA
utility and Cobb-Douglas technology with CRS, existence and uniqueness of
a steady state has just been proved. Asymptotic stability follows from (3.56).
So the CRRA-Cobb-Douglas case is well-behaved.
3.10
Exercises
(*)
where
is the aggregate capital stock and
is aggregate net saving. In
the Diamond model, let 1 be aggregate net saving of the young in period
and 2 aggregate net saving of the old in the same period. On the basis
of (*) give a direct proof that the link between two successive periods takes
the form +1 =
(1 + ) where
is the saving of each young, is the
population growth rate, and +1 is the capital/labor ratio at the beginning
of period + 1. Hint: by denition from accounting net saving is the same
as the increase in nancial wealth.
3.2 Suppose the production function in Diamonds OLG
1
(
+(1
) )1
0 0
1
0 and
nd the equilibrium real wage, ( ) b) Show that
for all
0 Hint: consider the roof. c) Comment on the
the long-run evolution of the economy.
model is
=
1+ . a) Given
( ) (1+ )
implication for
3.10. Exercises
107
kt+1
3
k
Figure 3.10: Transition curve for Diamonds OLG model in the case described in
Exercise 3.3.
b) Suppose the young in period 0 expect the real interest rate on their
saving to be relatively low. Describe by words the resulting equilibrium
path in this case. Comment (what is the economic intuition behind the
path?).
c) In the rst sentence under b), replace low by high. How is the
answer to b) a ected? What kind of di culty arises?
3.4 (plotting the transition curve by MATLAB) This exercise requires computation by a computer. You may use MATLAB OLG program.26
a) Enter the model specication from Exercise 3.3 and plot the transition
curve.
b) Plot examples for two other values of the substitution parameter:
1 0 and = 0 5 Comment.
c) Find the approximate largest lower bound for
of eliminates multiple equilibria.
26
Made
by
Marc
P.
B.
Klemp
and
available
http://www.econ.ku.dk/okocg/Computation/main.htm.
C. Groth, Lecture notes in macroeconomics, (mimeo) 2011
at
the
address
108
3.10. Exercises
109
110